Consider Priceline.com, the company made famous by William Shatner's ads about "naming your own price" for airline tickets and hotel rooms. In one of its quarterly SEC filings, Priceline reported that it earned $152 million in revenues. But that included the full amount customers paid for tickets, hotel rooms, and rental cars. Traditional travel agencies call that amount "gross bookings," not revenues. And much like regular travel agencies, Priceline keeps only a small portion of gross bookings—namely, the spread between the customers' accepted bids and the price it paid for the merchandise. The rest, which Priceline calls "product costs," it pays to the airlines and hotels that supply the tickets and rooms.

However, Priceline's product costs came to $134 million, leaving Priceline just $18 million of what it calls "gross profit" and what most other companies would call revenues. And that's before all of Priceline's other costs—like advertising and salaries—which netted out to a loss of $102 million. The difference isn't academic: Priceline stock traded at about 23 times its reported revenues but at a mind-boggling 214 times its "gross profit." This and other aggressive recognition practices led the SEC to issue stricter revenue recogniton guidance indicating that if a company performs as an agent or broker without assuming the risks and rewards of ownership of the goods, the company should report sales on a net (fee) basis. [1]

Source: Jeremy Kahn, "Presto Chango! Sales Are Huge," Fortune (March 20, 2000), p. 44.

In general, the guidelines for revenue recognition are quite broad. On top of the broad guidelines, certain industries have specific additional guidelines that provide further insight into when revenue should be recognized. The revenue recognition principle provides that companies should recognize revenue^[312] (1) when it is realized or realizable and (2) when it is earned.^[313] Therefore, proper revenue recognition revolves around three terms:

Four revenue transactions are recognized in accordance with this principle:

Revenues are inflows of assets and/or settlements of liabilities from delivering or producing goods, providing services, or other earning activities that constitute a company's ongoing major or central operations during a period.

These revenue transactions are diagrammed in Illustration 18-1.

Figure 18-1. Revenue Recognition Classified by Nature of Transaction

The preceding statements are the basis of accounting for revenue transactions. Yet, in practice there are departures from the revenue recognition principle. Companies sometimes recognize revenue at other points in the earning process, owing in great measure to the considerable variety of revenue transactions.^[315]

An FASB study found some common reasons for departures from the sale basis.^[316] One reason is a desire to recognize earlier than the time of sale the effect of earning activities. Earlier recognition is appropriate if there is a high degree of certainty about the amount of revenue earned. A second reason is a desire to delay recognition of revenue beyond the time of sale. Delayed recognition is appropriate if the degree of uncertainty concerning the amount of either revenue or costs is sufficiently high or if the sale does not represent substantial completion of the earnings process.

This chapter focuses on two of the four general types of revenue transactions described earlier: (1) selling products and (2) providing services. Both of these are sales transactions. (In several other sections of the textbook, we discuss the other two types of revenue transactions—revenue from permitting others to use enterprise assets, and revenue from disposing of assets other than products.) Our discussion of product sales transactions in this chapter is organized around the following topics:

Illustration 18-2 depicts this organization of revenue recognition topics.

Figure 18-2. Revenue Recognition Alternatives

If a company sells a product in one period and agrees to buy it back in the next accounting period, has the company sold the product? As indicated in Chapter 8, legal title has transferred in this situation. However, the economic substance of the transaction is that the seller retains the risks of ownership. The FASB has curtailed recognition of revenue using this practice. When a repurchase agreement exists at a set price and this price covers all cost of the inventory plus related holding costs, the inventory and related liability remain on the seller's books. [3] In other words, no sale.

Whether cash or credit sales are involved, a special problem arises with claims for returns and allowances. In Chapter 7, we presented the accounting treatment for normal returns and allowances. However, certain companies experience such a high rate of returns—a high ratio of returned merchandise to sales—that they find it necessary to postpone reporting sales until the return privilege has substantially expired.

For example, in the publishing industry, the rate of return approaches 25 percent for hardcover books and 65 percent for some magazines. Other types of companies that experience high return rates are perishable food dealers, distributors who sell to retail outlets, recording-industry companies, and some toy and sporting goods manufacturers. Returns in these industries are frequently made either through a right of contract or as a matter of practice involving "guaranteed sales" agreements or consignments.

This is an example of realized but unearned revenue. When high rates of return exist and cannot be reasonably estimated, a question arises as to whether the earnings process has been substantially completed.

Three alternative revenue recognition methods are available when the right of return exposes the seller to continued risks of ownership. These are: (1) not recording a sale until all return privileges have expired; (2) recording the sale, but reducing sales by an estimate of future returns; and (3) recording the sale and accounting for the returns as they occur. The FASB concluded that if a company sells its product but gives the buyer the right to return it, the company should recognize revenue from the sales transactions at the time of sale only if all of the following six conditions have been met. [4]

What if the six conditions are not met? In that case, the company must recognize sales revenue and cost of sales either when the return privilege has substantially expired or when those six conditions subsequently are met, whichever occurs first. In the income statement, the company must reduce sales revenue and cost of sales by the amount of the estimated returns.

Some companies record revenues at date of delivery with neither buyback nor unlimited return provisions. Although they appear to be following acceptable point-of-sale revenue recognition practices, they are recognizing revenues and earnings prematurely.

For example, the domestic cigarette industry at one time engaged in a distribution practice known as trade loading. As one commentator described this practice, "Trade loading is a crazy, uneconomic, insidious practice through which manufacturers—trying to show sales, profits, and market share they don't actually have—induce their wholesale customers, known as the trade, to buy more product than they can promptly resell."^[319] In total, the cigarette industry appears to have exaggerated a couple years' operating profits by as much as $600 million by taking the profits from future years.

International Insight

General revenue recognition principles are provided by iGAAP that are consistent with U.S. GAAP but contain limited detailed or industry-specific guidance.

In the computer software industry, a similar practice is referred to as channel stuffing. When a software maker needed to make its financial results look good, it offered deep discounts to its distributors to overbuy, and then recorded revenue when the software left the loading dock.^[320] Of course, the distributors' inventories become bloated and the marketing channel gets too filled with product, but the software maker's current-period financials are improved. However, financial results in future periods will suffer, unless the company repeats the process.

Trade loading and channel stuffing distort operating results and "window dress" financial statements. If used without an appropriate allowance for sales returns, channel stuffing is a classic example of booking tomorrow's revenue today. Business managers need to be aware of the ethical dangers of misleading the financial community by engaging in such practices to improve their financial statements.

Investors in Lucent Technologies were negatively affected when Lucent violated one of the fundamental criteria for revenue recognition—the "no take-back" rule. This rule holds that revenue should not be booked on inventory that is shipped if the customer can return it at some point in the future. In this particular case, Lucent agreed to take back shipped inventory from its distributors, if the distributors were unable to sell the items to their customers.

In essence, Lucent was "stuffing the channel." By booking sales when goods were shipped, even though they most likely would get them back, Lucent was able to report continued sales growth. However, Lucent investors got a nasty surprise when distributors returned those goods and Lucent had to restate its financial results. The restatement erased $679 million in revenues, turning an operating profit into a loss. In response to this bad news, Lucent's stock price declined $1.31 per share, or 8.5 percent. Lucent is not alone in this practice. Sunbeam got caught stuffing the sales channel with barbeque grills and other outdoor items, which contributed to its troubles when it was forced to restate its earnings.

Investors can be tipped off to potential channel stuffing by carefully reviewing a company's revenue recognition policy for generous return policies and by watching inventory and receivable levels. When sales increase along with receivables, that's one sign that customers are not paying for goods shipped on credit. And growing inventory levels are an indicator that customers have all the goods they need. Both scenarios suggest a higher likelihood of goods being returned and revenues and income being restated. So remember, no take-backs!

Source: Adapted from S. Young, "Lucent Slashes First Quarter Outlook, Erases Revenue from Latest Quarter," Wall Street Journal Online (December 22, 2000); and Tracey Byrnes, "Too Many Thin Mints: Spotting the Practice of Channel Stuffing," Wall Street Journal Online (February 7, 2002).

The percentage-of-completion method recognizes revenues, costs, and gross profit as a company makes progress toward completion on a long-term contract. To defer recognition of these items until completion of the entire contract is to misrepresent the efforts (costs) and accomplishments (revenues) of the accounting periods during the contract. In order to apply the percentage-of-completion method, a company must have some basis or standard for measuring the progress toward completion at particular interim dates.

Measuring the Progress toward Completion

As one practicing accountant wrote, "The big problem in applying the percentage-of-completion method ... has to do with the ability to make reasonably accurate estimates of completion and the final gross profit."^[323] Companies use various methods to determine the extent of progress toward completion. The most common are the cost-to-cost and units-of-delivery methods.^[324]

The objective of all these methods is to measure the extent of progress in terms of costs, units, or value added. Companies identify the various measures (costs incurred, labor hours worked, tons produced, floors completed, etc.) and classify them as input or output measures. Input measures (costs incurred, labor hours worked) are efforts devoted to a contract. Output measures (with units of delivery measured as tons produced, floors of a building completed, miles of a highway completed) track results. Neither are universally applicable to all long-term projects. Their use requires the exercise of judgment and careful tailoring to the circumstances.

Both input and output measures have certain disadvantages. The input measure is based on an established relationship between a unit of input and productivity. If inefficiencies cause the productivity relationship to change, inaccurate measurements result. Another potential problem is front-end loading, in which significant up-front costs result in higher estimates of completion. To avoid this problem, companies should disregard some early-stage construction costs—for example, costs of uninstalled materials or costs of subcontracts not yet performed—if they do not relate to contract performance.

Similarly, output measures can produce inaccurate results if the units used are not comparable in time, effort, or cost to complete. For example, using floors (stories) completed can be deceiving. Completing the first floor of an eight-story building may require more than one-eighth the total cost because of the substructure and foundation construction.

The most popular input measure used to determine the progress toward completion is the cost-to-cost basis. Under this basis, a company like EDS measures the percentage of completion by comparing costs incurred to date with the most recent estimate of the total costs required to complete the contract. Illustration 18-3 shows the formula for the cost-to-cost basis.

Figure 18-3. Formula for Percentage-of-Completion, Cost-to-Cost Basis

Once EDS knows the percentage that costs incurred bear to total estimated costs, it applies that percentage to the total revenue or the estimated total gross profit on the contract. The resulting amount is the revenue or the gross profit to be recognized to date. Illustration 18-4 shows this computation.

Figure 18-4. Formula for Total Revenue to Be Recognized to Date

To find the amounts of revenue and gross profit recognized each period, EDS subtracts total revenue or gross profit recognized in prior periods, as shown in Illustration 18-5.

Figure 18-5. Formula for Amount of Current-Period Revenue, Cost-to-Cost Basis

Because the cost-to-cost method is widely used (without excluding other bases for measuring progress toward completion), we have adopted it for use in our examples. [6]

Example of Percentage-of-Completion Method—Cost-to-Cost Basis

To illustrate the percentage-of-completion method, assume that Hardhat Construction Company has a contract to construct a $4,500,000 bridge at an estimated cost of $4,000,000. The contract is to start in July 2010, and the bridge is to be completed in October 2012. The following data pertain to the construction period. (Note that by the end of 2011 Hardhat has revised the estimated total cost from $4,000,000 to $4,050,000.)

Hardhat would compute the percentage complete as shown in Illustration 18-6.

Figure 18-6. Application of Percentage-of-Completion Method, Cost-to-Cost Basis

On the basis of the data above, Hardhat would make the following entries to record (1) the costs of construction, (2) progress billings, and (3) collections. These entries appear as summaries of the many transactions that would be entered individually as they occur during the year.

Figure 18-7. Journal Entries—Percentage-of-Completion Method, Cost-to-Cost Basis

In this example, the costs incurred to date are a measure of the extent of progress toward completion. To determine this, Hardhat evaluates the costs incurred to date as a proportion of the estimated total costs to be incurred on the project. The estimated revenue and gross profit that Hardhat will recognize for each year are calculated as shown in Illustration 18-8 (on page 941).

Figure 18-8. Percentage-of-Completion, Revenue and Gross Profit, by Year

Illustration 18-9 shows Hardhat's entries to recognize revenue and gross profit each year and to record completion and final approval of the contract.

Figure 18-9. Journal Entries to Recognize Revenue and Gross Profit and to Record Contract Completion—Percentage-of-Completion Method, Cost-to-Cost Basis

Note that Hardhat debits gross profit (as computed in Illustration 18-8) to Construction in Process. Similarly, it credits Revenue from Long-Term Contracts for the amounts computed in Illustration 18-8. Hardhat then debits the difference between the amounts recognized each year for revenue and gross profit to a nominal account, Construction Expenses (similar to Cost of Goods Sold in a manufacturing company). It reports that amount in the income statement as the actual cost of construction incurred in that period. For example, Hardhat uses the actual costs of $1,000,000 to compute both the gross profit of $125,000 and the percent complete (25 percent).

Hardhat continues to accumulate costs in the Construction in Process account, in order to maintain a record of total costs incurred (plus recognized profit) to date. Although theoretically a series of "sales" takes place using the percentage-of-completion method, the selling company cannot remove the inventory cost until the construction is completed and transferred to the new owner. Hardhat's Construction in Process account for the bridge would include the following summarized entries over the term of the construction project.

Figure 18-10. Content of Construction in Process Account—Percentage-of-Completion Method

Recall that the Hardhat Construction Company example contained a change in estimate: In the second year, 2011, it increased the estimated total costs from $4,000,000 to $4,050,000. The change in estimate is accounted for in a cumulative catch-up manner. This is done by, first, adjusting the percent completed to the new estimate of total costs. Next, Hardhat deducts the amount of revenues and gross profit recognized in prior periods from revenues and gross profit computed for progress to date. That is, it accounts for the change in estimate in the period of change. That way, the balance sheet at the end of the period of change and the accounting in subsequent periods are as they would have been if the revised estimate had been the original estimate.

Financial Statement Presentation—Percentage-of-Completion

Generally, when a company records a receivable from a sale, it reduces the Inventory account. Under the percentage-of-completion method, however, the company continues to carry both the receivable and the inventory. Subtracting the balance in the Billings account from Construction in Process avoids double-counting the inventory. During the life of the contract, Hardhat reports in the balance sheet the difference between the Construction in Process and the Billings on Construction in Process accounts. If that amount is a debit, Hardhat reports it as a current asset; if it is a credit, it reports it as a current liability.

At times, the costs incurred plus the gross profit recognized to date (the balance in Construction in Process) exceed the billings. In that case, Hardhat reports this excess as a current asset entitled "Cost and recognized profit in excess of billings." Hardhat can at any time calculate the unbilled portion of revenue recognized to date by subtracting the billings to date from the revenue recognized to date, as illustrated for 2010 for Hardhat Construction in Illustration 18-11.

Figure 18-11. Computation of Unbilled Contract Price at 12/31/10

At other times, the billings exceed costs incurred and gross profit to date. In that case, Hardhat reports this excess as a current liability entitled "Billings in excess of costs and recognized profit."

It probably has occurred to you that companies often have more than one project going at a time. When a company has a number of projects, costs exceed billings on some contracts and billings exceed costs on others. In such a case, the company segregates the contracts. The asset side includes only those contracts on which costs and recognized profit exceed billings. The liability side includes only those on which billings exceed costs and recognized profit. Separate disclosures of the dollar volume of billings and costs are preferable to a summary presentation of the net difference.

Using data from the bridge example, Hardhat Construction Company would report the status and results of its long-term construction activities under the perentage-of-completion method as shown in Illustration 18-12 (on page 943).

Figure 18-12. Financial Statement Presentation—Percentage-of-Completion Method

Under the completed-contract method, companies recognize revenue and gross profit only at point of sale—that is, when the contract is completed. Under this method, companies accumulate costs of long-term contracts in process, but they make no interim charges or credits to income statement accounts for revenues, costs, or gross profit.

The principal advantage of the completed-contract method is that reported revenue reflects final results rather than estimates of unperformed work. Its major disadvantage is that it does not reflect current performance when the period of a contract extends into more than one accounting period. Although operations may be fairly uniform during the period of the contract, the company will not report revenue until the year of completion, creating a distortion of earnings.

Under the completed-contract method, the company would make the same annual entries to record costs of construction, progress billings, and collections from customers as those illustrated under the percentage-of-completion method. The significant difference is that the company would not make entries to recognize revenue and gross profit.

For example, under the completed-contract method for the bridge project illustrated on the preceding pages, Hardhat Construction Company would make the following entries in 2012 to recognize revenue and costs and to close out the inventory and billing accounts.

International Insight

iGAAP prohibits the use of the completed-contract method of accounting for long-term construction contracts. Companies must use the percentage-of-completion method. If revenues and costs are difficult to estimate, then companies recognize revenue only to the extent of the cost incurred—a zero-profit approach.

Illustration 18-13 compares the amount of gross profit that Hardhat Construction Company would recognize for the bridge project under the two revenue-recognition methods.

Figure 18-13. Comparison of Gross Profit Recognized under Different Methods

Under the completed-contract method, Hardhat Construction would report its long-term construction activities as follows.

Figure 18-14. Financial Statement Presentation—Completed-Contract Method

Two types of losses can become evident under long-term contracts:^[325]

Conservatism justifies recognizing the losses immediately. Loss recognition does not require realization; it only requires evidence that an impairment of asset value has occurred.

The treatment described for unprofitable contracts is consistent with the accounting custom of anticipating foreseeable losses to avoid overstatement of current and future income (conservatism).

To illustrate a loss in the current period on a contract expected to be profitable upon completion, we'll continue with the Hardhat Construction Company bridge project. Assume that on December 31, 2011, Hardhat estimates the costs to complete the bridge contract at $1,468,962 instead of $1,134,000 (refer to page 940). Assuming all other data are the same as before, Hardhat would compute the percentage complete and recognize the loss as shown in Illustration 18-15. Compare these computations with those for 2011 in Illustration 18-6 (page 940). The "percent complete" has dropped, from 72 percent to 66½ percent, due to the increase in estimated future costs to complete the contract.

Figure 18-15. Computation of Recognizable Loss, 2011—Loss in Current Period

The 2011 loss of $48,500 is a cumulative adjustment of the "excessive" gross profit recognized on the contract in 2010. Instead of restating the prior period, the company absorbs the prior period misstatement entirely in the current period. In this illustration, the adjustment was large enough to result in recognition of a loss.

Hardhat Construction would record the loss in 2011 as follows.

Hardhat will report the loss of $48,500 on the 2011 income statement as the difference between the reported revenues of $1,867,500 and the costs of $1,916,000.^[326] Under the completed-contract method, the company does not recognize a loss in 2011. Why not? Because the company still expects the contract to result in a profit, to be recognized in the year of completion.

Loss on an Unprofitable Contract

To illustrate the accounting for an overall loss on a long-term contract, assume that at December 31, 2011, Hardhat Construction Company estimates the costs to complete the bridge contract at $1,640,250 instead of $1,134,000. Revised estimates for the bridge contract are as follows.

Under the percentage-of-completion method, Hardhat recognized $125,000 of gross profit in 2010 (see Illustration 18-8 on page 941). This amount must be offset in 2011 because it is no longer expected to be realized. In addition, since losses must be recognized as soon as estimable, the company must recognize the total estimated loss of $56,250 in 2011. Therefore, Hardhat must recognize a total loss of $181,250 ($125,000 + $56,250) in 2011.

Illustration 18-16 shows Hardhat's computation of the revenue to be recognized in 2011.

Figure 18-16. Computation of Revenue Recognizable, 2011—Unprofitable Contract

To compute the construction costs to be expensed in 2011, Hardhat adds the total loss to be recognized in 2011 ($125,000 + $56,250) to the revenue to be recognized in 2011. Illustration 18-17 shows this computation.

Figure 18-17. Computation of Construction Expense, 2011—Unprofitable Contract

Hardhat Construction would record the long-term contract revenues, expenses, and loss in 2011 as follows.

At the end of 2011, Construction in Process has a balance of $2,859,750 as shown below.^[327]

Figure 18-18. Content of Construction in Process Account at End of 2011—Unprofitable Contract

Under the completed-contract method, Hardhat also would recognize the contract loss of $56,250, through the following entry in 2011 (the year in which the loss first became evident).

Just as the Billings account balance cannot exceed the contract price, neither can the balance in Construction in Process exceed the contract price. In circumstances where the Construction in Process balance exceeds the billings, the company can deduct the recognized loss from such accumulated costs on the balance sheet. That is, under both the percentage-of-completion and the completed-contract methods, the provision for the loss (the credit) may be combined with Construction in Process, thereby reducing the inventory balance. In those circumstances, however (as in the 2011 example above), where the billings exceed the accumulated costs, Hardhat must report separately on the balance sheet, as a current liability, the amount of the estimated loss. That is, under both the percentage-of-completion and the completed-contract methods, Hardhat would take the $56,250 loss, as estimated in 2011, from the Construction in Process account and report it separately as a current liability titled "Estimated liability from long-term contracts." [7]

Construction contractors usually make some unique financial statement disclosures in addition to those required of all businesses. Generally these additional disclosures are made in the notes to the financial statements. For example, a construction contractor should disclose the following: the method of recognizing revenue, [8] the basis used to classify assets and liabilities as current (the nature and length of the operating cycle), the basis for recording inventory, the effects of any revision of estimates, the amount of backlog on uncompleted contracts, and the details about receivables (billed and unbilled, maturity, interest rates, retainage provisions, and significant individual or group concentrations of credit risk).

Halliburton provides engineering- and construction-related services, in jobs around the world. Much of the company's work is completed under contract over long periods of time. The company uses percentage-of-completion accounting. The SEC started enforcement proceedings against the company related to its accounting for contract claims and disagreements with customers, including those arising from change orders and disputes about billable amounts and costs associated with a construction delay.

Prior to 1998, Halliburton took a very conservative approach to its accounting for disputed claims. As stated in the company's 1997 annual report, "Claims for additional compensation are recognized during the period such claims are resolved." That is, the company waited until all disputes were resolved before recognizing associated revenues. In contrast, in 1998 the company recognized revenue for disputed claims before their resolution, using estimates of amounts expected to be recovered. Such revenue and its related profit are more tentative and are subject to possible later adjustment than revenue and profit recognized when all claims have been resolved. As a case in point, the company noted that it incurred losses of $99 million in 1998 related to customer claims.

The accounting method put in place in 1998 is more aggressive than the company's former policy, but it is still within the boundaries of generally accepted accounting principles. However, the SEC noted that over six quarters, Halliburton failed to disclose its change in accounting practice. In the absence of any disclosure the SEC believed the investing public was misled about the precise nature of Halliburton's income in comparison to prior periods. The Halliburton situation illustrates the difficulty of using estimates in percentage-of-completion accounting and the impact of those estimates on the financial statements.

Source: "Failure to Disclose a 1998 Change in Accounting Practice," SEC (August 3, 2004), www.sec.gov/news/press/2004-104.htm. See also "Accounting Ace Charles Mulford Answers Accounting Questions," Wall Street Journal Online (June 7, 2002).

In certain cases companies recognize revenue at the completion of production even though no sale has been made. Examples of such situations involve precious metals or agricultural products with assured prices. Under the completion-of-production basis, companies recognize revenue when these metals are mined or agricultural crops harvested because the sales price is reasonably assured, the units are interchangeable, and no significant costs are involved in distributing the product.^[328] (See discussion in Chapter 9, page 445, "Valuation at Net Realizable Value.")

This is not an exception to the revenue recognition principle. At the completion of production, realization is virtually assured and the earning process is substantially completed.

Likewise, when sale or cash receipt precedes production and delivery, as in the case of magazine subscriptions, companies recognize revenues as earned by production and delivery.^[329]

The installment-sales method recognizes income in the periods of collection rather than in the period of sale. The logic underlying this method is that when there is no reasonable approach for estimating the degree of collectibility, companies should not recognize revenue until cash is collected.

The expression "installment sales" generally describes any type of sale for which payment is required in periodic installments over an extended period of time. All types of farm and home equipment as well as home furnishings are sold on an installment basis. The heavy equipment industry also sometimes uses the method for machine installations paid for over a long period. Another application of the method is in land-development sales.

Because payment is spread over a relatively long period, the risk of loss resulting from uncollectible accounts is greater in installment-sales transactions than in ordinary sales. Consequently, selling companies use various devices to protect themselves. Two common devices are: (1) the use of a conditional sales contract, which specifies that title to the item sold does not pass to the purchaser until all payments are made, and (2) use of notes secured by a chattel (personal property) mortgage on the article sold. Either of these permits the seller to "repossess" the goods sold if the purchaser defaults on one or more payments. The seller can then resell the repossessed merchandise at whatever price it will bring to compensate for the uncollected installments and the expense of repossession.

Realization is a critical part of revenue recognition. Thus, if a high degree of uncertainty exists about collectibility, a company must defer revenue recognition.

Under the installment-sales method of accounting, companies defer income recognition until the period of cash collection. They recognize both revenues and costs of sales in the period of sale, but defer the related gross profit to those periods in which they collect the cash. Thus, instead of deferring the sale, along with related costs and expenses, to the future periods of anticipated collection, the company defers only the proportional gross profit. This approach is equivalent to deferring both sales and cost of sales. Other expenses—that is, selling expense, administrative expense, and so on—are not deferred.

Thus, the installment-sales method matches cost and expenses against sales through the gross profit figure, but no further. Companies using the installment-sales method generally record operating expenses without regard to the fact that they will defer some portion of the year's gross profit. This practice is often justified on the basis that (1) these expenses do not follow sales as closely as does the cost of goods sold, and (2) accurate apportionment among periods would be so difficult that it could not be justified by the benefits gained.^[330]

Procedure for Deferring Revenue and Cost of Sales of Merchandise

One could work out a procedure that deferred both the uncollected portion of the sales price and the proportionate part of the cost of the goods sold. Instead of apportioning both sales price and cost over the period of collection, however, the installment-sales method defers only the gross profit. This procedure has exactly the same effect as deferring both sales and cost of sales, but it requires only one deferred account rather than two.

For the sales in any one year, the steps companies use to defer gross profit are as follows.

1. During the year, record both sales and cost of sales in the regular way, using the special accounts described later, and compute the rate of gross profit on installment-sales transactions.

2. At the end of the year, apply the rate of gross profit to the cash collections of the current year's installment sales, to arrive at the realized gross profit.

3. Defer to future years the gross profit not realized.

For sales made in prior years, companies apply the gross profit rate of each year's sales against cash collections of accounts receivable resulting from that year's sales, to arrive at the realized gross profit.

Special accounts must be used in the installment-sales method. These accounts provide certain special information required to determine the realized and unrealized gross profit in each year of operations. In computing net income under the installment-sales method as generally applied, the only peculiarity is the deferral of gross profit until realized by accounts receivable collection. We will use the following data to illustrate the installment-sales method in accounting for the sales of merchandise.

To simplify this example, we have excluded interest charges. Summary entries in general journal form for the year 2010 are as follows.

Illustration 18-19 shows computation of the realized and deferred gross profit for the year 2010.

Figure 18-19. Computation of Realized and Deferred Gross Profit, 2010

Summary entries in journal form for year 2 (2011) are as follows.

Illustration 18-20 shows computation of the realized and deferred gross profit for the year 2011.

Figure 18-20. Computation of Realized and Deferred Gross Profit, 2011

The entries in 2012 would be similar to those of 2011, and the total gross profit taken up or realized would be $64,000, as shown by the computations in Illustration 18-21.

Figure 18-21. Computation of Realized and Deferred Gross Profit, 2012

In summary, here are the basic concepts you should understand about accounting for installment sales:

1. How to compute a proper gross profit percentage.

2. How to record installment sales, cost of installment sales, and deferred gross profit.

3. How to compute realized gross profit on installment receivables.

4. How the deferred gross profit balance at the end of the year results from applying the gross profit rate to the installment accounts receivable.

Additional Problems of Installment-Sales Accounting

In addition to computing realized and deferred gross profit currently, other problems are involved in accounting for installment-sales transactions. These problems are related to:

1. Interest on installment contracts.

2. Uncollectible accounts.

3. Defaults and repossessions.

Interest on Installment Contracts. Because the collection of installment receivables is spread over a long period, it is customary to charge the buyer interest on the unpaid balance. The seller and buyer set up a schedule of equal payments consisting of interest and principal. Each successive payment is attributable to a smaller amount of interest and a correspondingly larger amount of principal, as shown in Illustration 18-22. This illustration assumes that a company sells for $3,000 an asset costing $2,400 (rate of gross profit = 20%), with interest of 8 percent included in the three installments of $1,164.10.

Figure 18-22. Installment Payment Schedule

The company accounts for interest separate from the gross profit recognized on the installment-sales collections during the period, by recognizing interest revenue at the time of its cash receipt.

Uncollectible Accounts. The problem of bad debts or uncollectible accounts receivable is somewhat different for concerns selling on an installment basis because of a repossession feature commonly incorporated in the sales agreement. This feature gives the selling company an opportunity to recoup an uncollectible account through repossession and resale of repossessed merchandise. If the experience of the company indicates that repossessions do not, as a rule, compensate for uncollecible balances, it may be advisable to provide for such losses through charges to a special bad debt expense account, just as is done for other credit sales.

Defaults and Repossessions. Depending on the terms of the sales contract and the policy of the credit department, the seller can repossess merchandise sold under an installment arrangement if the purchaser fails to meet payment requirements. The seller may then recondition repossessed merchandise before offering it for re-sale, for cash or installment payments.

The accounting for repossessions recognizes that the company is not likely to collect the related installment receivable and should write it off. Along with the installment account receivable, the company must remove the applicable deferred gross profit using the following entry:

This entry assumes that the company will record the repossessed merchandise at exactly the amount of the uncollected account less the deferred gross profit applicable. This assumption may or may not be proper. To determine the correct amount, the company should consider the condition of the repossessed merchandise, the cost of reconditioning, and the market for second-hand merchandise of that particular type. The objective should be to put any asset acquired on the books at its fair value, or at the best possible approximation of fair value when fair value is not determinable. A loss can occur if the fair value of the repossessed merchandise is less than the uncollected balance less the deferred gross profit. In that case, the company should record a "loss on repossession" at the date of repossession.^[332]

To illustrate the required entry, assume that Klein Brothers sells a refrigerator to Marilyn Hunt for $1,500 on September 1, 2010. Terms require a down payment of $600 and $60 on the first of every month for 15 months, starting October 1, 2010. It is further assumed that the refrigerator cost $900, and that Klein Brothers priced it to provide a 40 percent rate of gross profit on selling price. At the year-end, December 31, 2010, Klein Brothers should have collected a total of $180 in addition to the original down payment.

If Hunt makes her January and February payments in 2011 and then defaults, the account balances applicable to Hunt at time of default are as shown in Illustration 18-23.

Figure 18-23. Computation of Installment Receivable Balances

As indicated, Klein Brothers compute the balance of deferred gross profit applicable to Hunt's account by applying the gross profit rate for the year of sale to the balance of Hunt's account receivable: 40 percent of $600, or $240. The account balances are therefore:

Klein repossesses the refrigerator following Hunt's default. If Klein sets the estimated fair value of the repossessed article at $150, it would make the following entry to record the repossession.

Klein determines the amount of the loss in two steps: (1) It subtracts the deferred gross profit from the amount of the account receivable, to determine the unrecovered cost (or book value) of the merchandise repossessed. (2) It then subtracts the estimated fair value of the merchandise repossessed from the unrecovered cost, to get the amount of the loss on repossession. Klein Brothers computes the loss on the refrigerator as shown in Illustration 18-24.

Figure 18-24. Computation of Loss on Repossession

As pointed out earlier, the loss on repossession may be charged to Allowance for Doubtful Accounts if a company carries such an account.

Financial Statement Presentation of Installment-Sales Transactions

If installment-sales transactions represent a significant part of total sales, it is desirable to make full disclosure of installment sales, the cost of installment sales, and any expenses allocable to installment sales. However, if installment-sales transactions constitute an insignificant part of total sales, it may be satisfactory to include only the realized gross profit in the income statement as a special item following the gross profit on sales. Illustration 18-25 shows this simpler presentation.

Figure 18-25. Disclosure of Installment-Sales Transactions—Insignificant Amount

If a company wants more complete disclosure of installment-sales transactions, it would use a presentation similar to that shown in Illustration 18-26.

Figure 18-26. Disclosure of Installment-Sales Transactions—Significant Amount

The presentation in Illustration 18-26 is awkward. Yet the awkwardness of this method is difficult to avoid if a company wants to provide full disclosure of installment-sales transactions in the income statement. One solution, of course, is to prepare a separate schedule showing installment-sales transactions, with only the final figure carried into the income statement.

In the balance sheet it is generally considered desirable to classify installment accounts receivable by year of collectibility. There is some question as to whether companies should include in current assets installment accounts that are not collectible for two or more years. Yet if installment sales are part of normal operations, companies may consider them as current assets because they are collectible within the operating cycle of the business. Little confusion should result from this practice if the company fully discloses maturity dates, as illustrated in the following example.

Figure 18-27. Disclosure of Installment Accounts Receivable, by Year

On the other hand, a company may have receivables from an installment contract, resulting from a transaction not related to normal operations. In that case, the company should report such receivable in the "Other assets" section if due beyond one year.

Repossessed merchandise is a part of inventory, and companies should report it as such in the "Current assets" section of the balance sheet. They should include any gain or loss on repossession in the income statement in the "Other revenues and gains" or "Other expenses and losses" section.

If a company has deferred gross profit on installment sales, it generally treats it as unearned revenue and classifies it as a current liability. Theoretically, deferred gross profit consists of three elements: (1) income tax liability to be paid when the sales are reported as realized revenue (current liability); (2) allowance for collection expense, bad debts, and repossession losses (deduction from installment accounts receivable); and (3) net income (retained earnings, restricted as to dividend availability). Because of the difficulty in allocating deferred gross profit among these three elements, however, companies frequently report the whole amount as unearned revenue.

In contrast, the FASB in SFAC No. 6 states that "no matter how it is displayed in financial statements, deferred gross profit on installment sales is conceptually an asset valuation—that is, a reduction of an asset."^[333] We support the FASB position, but we recognize that until an official standard on this topic is issued, financial statements will probably continue to report such deferred gross profit as a current liability.

Under the cost-recovery method, a company recognizes no profit until cash payments by the buyer exceed the cost of the merchandise sold. After the seller has recovered all costs, it includes in income any additional cash collections. The seller's income statement for the period reports sales revenue, the cost of goods sold, and the gross profit—both the amount (if any) that is recognized during the period and the amount that is deferred. The deferred gross profit is offset against the related receivable—reduced by collections—on the balance sheet. Subsequent income statements report the gross profit as a separate item of revenue when the company recognizes it as earned.

A seller is permitted to use the cost-recovery method to account for sales in which "there is no reasonable basis for estimating collectibility." In addition, use of this method is required where a high degree of uncertainty exists related to the collection of receivables. [11], [12], [13]

To illustrate the cost-recovery method, assume that early in 2010, Fesmire Manufacturing sells inventory with a cost of $25,000 to Higley Company for $36,000. Higley will make payments of $18,000 in 2010, $12,000 in 2011, and $6,000 in 2012. If the cost-recovery method applies to this transaction and Higley makes the payments as scheduled, Fesmire recognizes cash collections, revenue, cost, and gross profit as follows.^[334]

Figure 18-28. Computation of Gross Profit—Cost-Recovery Method

Under the cost-recovery method, Fesmire reports total revenue and cost of goods sold in the period of sale, similar to the installment-sales method. However, unlike the installment-sales method, which recognizes income as cash is collected, Fesmire recognizes profit under the cost-recovery method only when cash collections exceed the total cost of the goods sold.

Therefore, Fesmire's journal entry to record the deferred gross profit on the Higley sale transaction (after recording the sale and the cost of sale in the normal manner) at the end of 2010 is as follows.

In 2011 and 2012, the deferred gross profit becomes realized gross profit as the cumulative cash collections exceed the total costs, by recording the following entries.

Suppose you purchased a gift card for spa services at Sundara Spa for $300. The gift card expires at the end of six months. When should Sundara record the revenue? Here are two choices:

If you answered number 2, you would be right. Companies should recognize revenue when the obligation is satisfied—which is when Sundara performs the service.

Now let's add a few more facts. Suppose that the gift-card holder fails to use the card in the six-month period. Statistics show that between 2 and 15 percent of gift-card holders never redeem their cards. So, do you still believe that Sundara should record the revenue at the expiration date?

If you say you are not sure, you are probably right. Here is why: Certain states (such as California) do not recognize expiration dates, and therefore the customer has the right to redeem an otherwise expired gift card at any time. Let's for the moment say we are in California. Because the card holder may never redeem, when can Sundara recognize the revenue? In that case Sundara would have to show statistically that after a certain period of time, the likelihood of redemption is remote. If it can make that case, it can recognize the revenue. Otherwise it may have to wait a long time.

Unfortunately Sundara may still have a problem. It may be required to turn over the value of the spa service to the state. The treatment for unclaimed gift cards may fall under the state abandoned-and-unclaimed-property laws. Most common unclaimed items are required to be remitted to the states after a five-year period. Failure to report and remit the property can result in additional fines and penalties. So if Sundara is in a state where unclaimed property must be sent to the state, Sundara should report a liability on its balance sheet.

Source: PricewaterhouseCoopers, "Issues Surrounding the Recognition of Gift Card Sales and Escheat Liabilities," Quick Brief (December 2004).

In some cases, a company receives cash from the buyer before it transfers the goods or property. In such cases the seller has not performed under the contract and has no claim against the purchaser. There is not sufficient transfer of the risks and rewards of ownership for a sale to be recorded. The method of accounting for these incomplete transactions is the deposit method.

Under the deposit method the seller reports the cash received from the buyer as a deposit on the contract and classifies it on the balance sheet as a liability (refundable deposit or customer advance). The seller continues to report the property as an asset on its balance sheet, along with any related existing debt. Also, the seller continues to charge depreciation expense as a period cost for the property. The seller does not recognize revenue or income until the sale is complete. [14] At that time, it closes the deposit account and applies one of the revenue recognition methods discussed in this chapter to the sale.

The major difference between the installment-sales and cost-recovery methods and the deposit method relates to contract performance. In the installment-sales and cost-recovery methods it is assumed that the seller has performed on the contract, but cash collection is highly uncertain. In the deposit method, the seller has not performed and no legitimate claim exists. The deposit method postpones recognizing a sale until the company determines that a sale has occurred for accounting purposes. If there has not been sufficient transfer of risks and rewards of ownership, even if the selling company has received a deposit, the company postpones recognition of the sale until sufficient transfer has occurred. In that sense, the deposit method is not a revenue recognition method as are the installment-sales and cost-recovery methods.

Illustration 18-29 summarizes the revenue-recognition bases or methods, the criteria for their use, and the reasons for departing from the sale basis.^[335]

Figure 18-29. Revenue Recognition Bases Other Than the Sale Basis for Products

As mentioned, iGAAP does not permit the completed-contract method of accounting for long-term construction contracts. If costs or revenues cannot be reliably determined, then how does a company report revenues related to its construction contracts using iGAAP? To illustrate, assume the following facts for England Construction Co. for a contract to build a dam at Windswept Canyon.

In this situation, England recognizes revenue up to the cost incurred until the cost numbers can be more reliably determined. For example, assume that England incurred $55 million in costs in 2010. The presentation on its income statement would be as follows.

Under iGAAP, zero profit is recognized. Once costs can be reliably determined, the percentage-of-completion method is used in future periods.

The FASB and IASB are now involved in a joint project on revenue recognition. The objective of the project is to develop coherent conceptual guidance for revenue recognition and a comprehensive statement on revenue recognition based on those concepts. In particular, the project is intended to improve financial reporting by (1) converging U.S. and international standards on revenue recognition, (2) eliminating inconsistencies in the existing conceptual guidance on revenue recognition, (3) providing conceptual guidance that would be useful in addressing future revenue recognition issues, (4) eliminating inconsistencies in existing standards-level authoritative literature and accepted practices, (5) filling voids in revenue recognition guidance that have developed over time, and (6) establishing a single, comprehensive standard on revenue recognition. Presently, the Boards are evaluating a "customer-consideration" model. It is hoped that this approach (rather than using the earned and realized or realized criteria) will lead to a better basis for revenue recognition. For more on this topic, see http://www.fasb.org/project/revenue_recognition.shtml.

The initial franchise fee is payment for establishing the franchise relationship and providing some initial services. Franchisors record initial franchise fees as revenue only when and as they make "substantial performance" of the services they are obligated to perform and when collection of the fee is reasonably assured. Substantial performance occurs when the franchisor has no remaining obligation to refund any cash received or excuse any nonpayment of a note and has performed all the initial services required under the contract. Commencement of operations by the franchisee shall be presumed to be the earliest point at which substantial performance has occurred, unless it can be demonstrated that substantial performance of all obligations, including services rendered voluntarily, has occurred before that time. [15]

Continuing franchise fees are received in return for the continuing rights granted by the franchise agreement and for providing such services as management training, advertising and promotion, legal assistance, and other support. Franchisors report continuing fees as revenue when they are earned and receivable from the franchisee, unless a portion of them has been designated for a particular purpose, such as providing a specified amount for building maintenance or local advertising. In that case, the portion deferred shall be an amount sufficient to cover the estimated cost in excess of continuing franchise fees and provide a reasonable profit on the continuing services.

In addition to paying continuing franchise fees, franchisees frequently purchase some or all of their equipment and supplies from the franchisor. The franchisor would account for these sales as it would for any other product sales.

Sometimes, however, the franchise agreement grants the franchisee the right to make bargain purchases of equipment or supplies after the franchisee has paid the initial franchise fee. If the bargain price is lower than the normal selling price of the same product, or if it does not provide the franchisor a reasonable profit, then the franchisor should defer a portion of the initial franchise fee. The franchisor would account for the deferred portion as an adjustment of the selling price when the franchisee subsequently purchases the equipment or supplies.

A franchise agreement may give the franchisor an option to purchase the franchisee's business. As a matter of management policy, the franchisor may reserve the right to purchase a profitable franchise outlet, or to purchase one that is in financial difficulty.

If it is probable at the time the option is given that the franchisor will ultimately purchase the outlet, then the franchisor should not recognize the initial franchise fee as revenue but should instead record it as a liability. When the franchisor exercises the option, the liability would reduce the franchisor's investment in the outlet.

Franchise accounting also involves proper accounting for the franchisor's cost. The objective is to match related costs and revenues by reporting them as components of income in the same accounting period. Franchisors should ordinarily defer direct costs (usually incremental costs) relating to specific franchise sales for which revenue has not yet been recognized. They should not, however, defer costs without reference to anticipated revenue and its realizability. [16] Indirect costs of a regular and recurring nature, such as selling and administrative expenses that are incurred irrespective of the level of franchise sales, should be expensed as incurred.

Franchisors must disclose all significant commitments and obligations resulting from franchise agreements, including a description of services that have not yet been substantially performed. They also should disclose any resolution of uncertainties regarding the collectibility of franchise fees. Franchisors segregate initial franchise fees from other franchise fee revenue if they are significant. Where possible, revenues and costs related to franchisor-owned outlets should be distinguished from those related to franchised outlets.

Go to the book's companion website, at www.wiley.com/college/kieso, to find an interactive problem that simulates the computerized CPA exam. The professional simulation for this chapter asks you to address questions related to the accounting for revenue recognition.